This is a common perception, but unfortunately it is not true.

As a quick test: what percentage of a repayment mortgage do you think is paid off in the first 5 years, or 20%, of the typical 25 year loan term? Let’s assume the loan is for #200,000 and the interest rate is 7%, which approximates the mortgages available in the UK today (July 2009).

Most people would guess that about 20% of the loan, or 40,000 pounds, is paid off in this time. This is a reasonable assumption and makes intuitive sense, as we commonly assume that debt is paid off evenly over the length of a loan. However, it may be a surprise to discover that in the early years of the mortgage most of the ~#1400 monthly repayment in this example goes towards paying off the total loan interest (which is the bank’s profit, which they want as soon as possible), rather than the actual debt. The majority of the debt repayment is actually paid towards the end of the loan. This is called loan amortisation (or amortization if you are American), and as a result you will have paid off not #40,000, but just #18,000 after the first 5 years of this mortgage, or less than 10% of the debt.

How Many People Understand the Repayment Model?

40% of the Loan Term to Pay Off 20% of the Capital

In reality, as discussed in more detail in the previous section, the property ladder was historically based not upon paying off the capital of the loan, but instead upon high inflation, and thus high earnings growth, eroding the debt and payments as a percentage of your salary. For instance, in the 1970s, high inflation drove high annual wage increases, meaning that the burden of a given debt relative to income decreased rapidly over the years. At 20% wage inflation, as occurred during the 1975, the burden of a debt that took 60% of take home pay in the 1st year took just 50% in the 2nd year (i.e. the same as 5 years today), 41% in the second year, & 34% in the 3rd year, by which your payments would have approximately halved relatively to salary and you may have been ready to trade up. This would have occurred even though a 20% interest rate on the loan you would meant that you would have only paid off ~1% of the actual debt. In contrast, if wage growth is 2%, as today, then at the end of the 3rd year of the loan an initial debt burden of 60% of take home pay would still require 56% of take home pay. This is clearly a significant difference. It is inflation, not debt repayment, that enabled past mortgage holders rapidly trade up.

Trading Up is Harder in a Low Inflation World

Smaller Steps with More Debt

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